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State finances are on the mend, presenting a new wrinkle for holders of tax-free municipal bonds: A handful of states are pushing to cut income-tax rates. That could cause their bonds to underperform in coming years by reducing local demand for them.

Chief among states investors should underweight are Kansas, Oklahoma, North Carolina, Nebraska, and Louisiana, says Dan Heckman, the chief bond strategist at U.S. Bank Wealth Management.

Don't cry for me, North Carolina: Lower state taxes would reduce in-state demand for munis, driving prices down and yields up.
Stuart Goldenberg for Barron's

State tax revenues have increased for 11 quarters running, fueled by a recovery in home prices, which has boosted property-tax revenue, according to an analysis provided by investment firm BlackRock. Meanwhile, states made unprecedented spending cuts during the Great Recession. General expenditures fell 3.8% in 2009 and 5.7% in 2010, after rising by an average of more than 7% over the prior four years. As a result of closing deficits, all but two states—Massachusetts and South Carolina—were able to pass fiscal 2013 budgets before the start of the fiscal year.

Now, proposals have surfaced to cut or eliminate state income taxes in Arkansas, Indiana, Iowa, Louisiana, North Carolina, Ohio, Oklahoma, and Wisconsin. Two factors give such proposals a decent chance. First, 39 states now have one-party control of their legislatures and governorships, the most since 1952, and 24 of these are controlled by Republicans, the party pushing hardest for lower income tax rates.

The second factor is competition. Kansas Gov. Sam Brownback succeeded last year in slashing tax rates for high earners and eliminating them for many businesses in what he calls a path to zero income tax. The cuts will cost the state more than $850 million a year in revenue, which Brownback hopes to offset by extending a sales tax that's set to expire and ending some deductions. A tax cut in one state forces neighboring ones to consider following suit in order to avoid seeing high-income residents defect, says Heckman.

Whether a particular voter thinks Brownback's tax cut is wise depends more on political leanings than knowable economic truths. A Republican might say that lower taxes will support economic growth and raise revenue in the long run, while a Democrat might argue that reduced revenue will force underinvestment in areas like education that are important to long-term growth. But muni-bond investors should put their politics aside and focus on short-term factors affecting bond demand.

Muni income generally escapes federal taxes, along with state taxes for those who buy bonds in their home states. The higher a buyer's state tax rate, the more attractive in-state bonds become compared with those from out of state. That means that all else held equal, bonds from high-tax states generally fetch higher prices and offer lower yields.

For example, Florida and North Carolina both have triple-A credit ratings from Standard & Poor's, but Florida 10-year general-obligation bonds recently yielded 2.5%, while North Carolina's yielded 2%. Florida has no income tax. North Carolina has a top income-tax rate of 7.75%, the 10th-highest in the nation. State Sen. Bob Rucho and other Republican lawmakers there are pushing to replace the state's income tax with a sales tax. If they succeed, prices on North Carolina munis could fall to bring yields closer to Florida's.

THAT'S REASON FOR CAUTION, but not panic. Federal taxes are higher than state levies, and those rose this year, increasing broad demand for munis. The hit for bonds in states that chop taxes could be on the order of a 5% price reduction over three years, says Heckman, possibly wiping out much of the income over that period. The exact performance will depend on a variety of factors, like how high rates were to begin with and whether those states are able to make up the revenue from other sources.

Better Muni Bets

Tax cuts in some states could crimp local demand for munis and cause prices to dip. Florida and Texas are safe bets because they have no income taxes to cut. A bonus: They have relatively generous yields. Below are four examples

Yield to

Call

Florida Board of Ed PECO 5% of 2023

2.31%

Florida Turnpike 4% of 2033

3.43

Houston Independent School Dist. 5% of 2023

2.20

Texas Transportation Commission 5% of 2033

2.80

Source: Municipal Market Advisors

During the Great Recession, fears of widespread municipal defaults caused bond prices to plunge, hiking yields well above those available on Treasury or even corporate bonds. That made muni yields attractive even for buyers who didn't need the tax breaks. The default wave never came, and investors who bought in a few years ago have secured both higher income and generous price appreciation as munis regained favor. But now a 10-year, triple-A general-obligation muni yields 89% as much as the 10-year Treasury note, close to the historic average and well below the 115% level seen just last September, according to data from investment firm Robert W. Baird.

Much of the cheapness of munis is gone, says Peter Hayes, the muni chief at BlackRock. Today's buyers should focus purely on the income they receive and not count on further gains.

U.S. Bank's Heckman foresees a bigger muni price impact than does Hayes, but the two agree on one thing: A safe bet for investors for now is to diversify their home-state bond portfolio with bonds from income-tax-free states. A buyer in, say, New York, might put two-thirds of his portfolio in New York bonds for their added tax breaks, and then look to Texas and Florida for diversification, as well as higher yields. If a spate of tax cuts from the likes of Kansas and North Carolina do push prices down in those states, investors can scoop them up afterward at lower prices and higher yields.